SPCS

Form 4 Principles of Accounts

Notes on Chapter 7
The Trading and Profit and Loss Account – Part I

7.1 Purposes of the trading and profit and loss account

People run businesses to try to make a profit. If they are not successful, they may lose money. To
calculate how much profit has been made over a period of time, a trading and profit and loss account
is prepared.

Normally, all businesses prepare trading and profit and loss accounts at least once a year. They could
be prepared for a lesser period if required. They can be prepared on a monthly or quarterly basis to
provide timely information for internal use.

The main purpose of a trading and profit and loss account is for the owners to see how profitable the
business is. It is also used for other purposes. For example, the Commissioner of Inland Revenue will
want to see it so that he or she can assess how much tax the business is required to pay. Moreover,
the banker may want to see it before he or she decides to make a loan to the business.

New Term:

Trading and Profit and Loss Account

- A combined account in which both gross and net profits are calculated.
- A summary of a firm’s trading and operational performance for a given period of time.

7.2 Uses of the trading and profit and loss accounts

One of the most important uses of the trading and profit and loss account is the comparison of the
results achieved with those of past periods. When doing this, it enables the traders to find out following
two sorts of profits:

Gross Profit - The difference between the proceeds from sales of goods
(calculated in the Trading and the direct cost of those goods sold.
account) - The excess of sales over the cost of goods sold over a
period.
= Sales – cost of goods sold
Net Profit - The balance of the gross trading profit after deducting all
(calculated in the Profit other expenses of the business.
and Loss account) - What is left of the gross profit after all the expenses have
been deducted.
= Gross profit – expenses

New Terms:

Gross Profit
- Gross profit is found by deducting cost of goods sold from sales.

Net Profit
- Net profit is gross profit (plus other income) less expenses.

It would be possible to have one account called the trading account, and another called the profit and
loss account. Normally they are combined together to form one trading and profit and loss account.

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Mr. D. Ko
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Form 4 Principles of Accounts
7.3 Preparation of a trading and profit and loss account
Before drawing up a trading and profit and loss account, you should prepare a trial balance to see
whether there are any arithmetic errors in the accounts. Adjusting entries will have to be made should
there be any errors in the accounts.

In practice, a second trial balance is prepared after the adjustments to ensure that the accounts reflect a
fairer view of income and expenditure for the period.

Assuming that there is no adjustment needed in the trial balance, the basic procedures in preparing a
simple Trading and Profit and Loss account are as follows:

STEP 1: Transfer the credit balance of the Sales account to the credit of the Trading account portion of
the Trading and Profit and Loss account.

Debit: Sales account

Credit: Trading account

STEP 2: Transfer the debit balance of the Purchases account to the debit side of the Trading account.

Debit: Trading account

Credit: Purchases account

Remember, in this case there is no stock of unsold goods. This means that:
Purchases = Cost of Goods Sold.

STEP 3: If sales are greater than cost of goods sold, the difference is gross profit (If not, the answer
would be a gross loss). We will carry this gross profit figure from the Trading account part down to the
profit and loss section. The double entry for gross profit is:

Debit: Trading account

Credit: Profit and loss account

Notice that after the Trading account has been completed, there are no balances remaining in the sales
and purchases accounts. They are now closed.

STEP 4: Transfer the debit balances on Expenses accounts to the debit of the Profits and Loss account.

Debit: Profit and loss account

Credit: Expenses accounts

STEP 5: Transfer the net profit (if any), to the Capital account to show the increase in capital:

Debit: Profit and loss account

Credit: Capital account

7.4 Completion of capital account

You have seen that in STEP 5, we credit the capital account with the amount of net profit. We have
therefore recorded the increase in capital.

In the trial balance, whenever there are drawings, they mean withdrawals of capital. After entering the
net profit in the capital account, we can now complete the account. To do this, we transfer the drawings
to the capital account. The double entry is:

Debit: Capital account

Credit: Drawings account

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Mr. D. Ko
 SPCS
Form 4 Principles of Accounts
7.5 Example
Using the trial balance used below (in the Form Test), prepare the Trading and Profit and Loss account for
Mr. Wong for the month ended 30 June 2003.

Mr. Wong
Trial Balance as at 1 July 2003
Amount Amount
Debit (Dr) Credit (Cr)
Name of Accounts $ $
Bank 114,250
Cash 8,350
Office Equipment 4,000
Purchases 9,800
Carriage Inwards 300
Rates 225
Mr. Yu 5,000
Gary 7,200
Returns Outwards 3,600
Insurance Premium 1,100
Sales 6,700
Carriage Outwards 350
Derek 1,600
Drawings 5,025
Capital 122,500
145,000 145,000

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Mr. D. Ko